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On the Desirability of a Regional Basket Currency Arrangement

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On the Desirability of a Regional Basket Currency Arrangement 1%(5:25.,1*3$3(56(5,(6 217+('(6,5$%,/,7<2)$5(*,21$/ %$6.(7&855(1&<$55$1*(0(17 (LML2JDZD 7DNDWRVKL,WR :RUNLQJ3DSHU KWWSZZZQEHURUJSDSHUVZ 1$7,21$/%85($82)(&2120,&5(6($5&+ 0DVVD.KXVHWWV$YHQXH &DPEULGJH30$ 1RYHPEHU 7KLVSDSHUZDVSUHVHQWHGDWWKH&(3,,.,(3$'%,RQIHUHQH'HHPEHU7KHDXWKRUVDUH JUDWHIXOWR*DQJ<L.HQLKL2KQRDQGRWKHUSDUWLLSDQWVRIWKHUHIHUHQHDQGWRDQRQ\PRXVUHIHUHHIRU XVHIXODQGRQVWUXWLYHRPPHQWV9LHZVH[SUHVVHGKHUHDUHDXWKRUV¶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Introduction One of the lessons from the Asian Currency Crises is the danger of the de facto dollar peg adopted by the Asian economies that had extensive trade and investment relationship with countries other than the United States.1 When the yen appreciated vis-à-vis the US dollar, the Asian economies enjoyed the boom, or a bubble in some cases, due to increased exports. But, when the yen depreciated, the Asian economies tended to experience a recession, or a burst bubble. The experience of the Asian boom and bust in the 1990s, along with the yen-dollar exchange rate fluctuation, is a stark reminder of risk of the fixed exchange rate regime. An obvious solution for this problem is to increase flexibility of the exchange rate. If the baht had appreciated during the yen appreciation phase of the 1993-95, the extent of overheating in Thailand might have been limited; and if the baht had depreciated along with the yen in 1996-97, then the decline in exports could have been mitigated. This kind of exchange rate flexibility can be achieved by a flexible exchange rate regime which keeps the real effective exchange rate relatively stable. An obvious insight here is that an emerging market economy, which exports 3 to the United States and Japan, is well advised to consider managed exchange rate regimes, in order to avoid excessive volatility of the real effective exchange rate. 2 The questions to be considered include how to determine a reference rate as an appropriate real effective exchange rate and how much fluctuation is excessive. The optimality of the exchange rate regime is defined as the one that minimizes the fluctuation of the trade balances, when the yen-dollar exchange rate fluctuates. Ito, Ogawa, and Sasaki (1998) proposed how to calculate the optimal weights when the emerging market economy exports to Japan and the United States only. The optimal weights were calibrated with some assumptions on the demand elasticities and export shares. In this paper, we extend the Ito, Ogawa, and Sasaki model to include a neighboring emerging market as well as Japan and the United States. A typical Asian economy exports about one-third to the United States and one-third to Japan, and the rest to countries in the Asian region (and EU). Therefore, to simplify, we consider the case that country A (B, respectively) exports to the U.S., Japan, and country B (A, respectively). Therefore, the real effective exchange rate calculation includes the currency of neighboring country. What makes difficult and interesting in this model is 4 that the optimal weights may depend on what the neighboring country is adopting as weights. In the extreme case, if country A is adopting the dollar peg, country B should adopt the dollar peg; and if country B is adopting the dollar peg, then country A should adopt the dollar peg. Namely, the dollar peg is a Nash equilibrium. However, if country A is using a currency basket which mirrors the export shares, adjusted for demand elasticities, then country B should adopt a (similar) currency basket; and if country B is using a currency basket, then country A should adopt a currency basket. This trade-weighted currency basket is also a Nash equilibrium. Although the paper is motivated by the recent Asian experiences, the application is not limited to Asia. Results obtained in this paper are relevant to any developing countries with a trading structure with export destinations including different currency areas. Which of the Nash equilibria is chosen depends on the inertia as well as rational calculation. If countries can coordinate, then they should choose the best among Nash equilibria. This process of choosing the optimal Nash equilibrium can be regarded as a regional currency arrangement. Coordination failure could occur if a country has some obstacles for coordination from 5 political or social obstacles against breaking inertia. What this paper shows is that coordinate managed float by the two countries would increase the stability in the trade balance fluctuations. The rest of the paper is organized as follows. Section 2 explains the model. We assume that the Marshall-Lerner condition, which means that depreciation of the local currency will increase the net trade surpluses, is satisfied throughout the paper. Section 3 examines what the Marshall-Lerner condition implies in our oligopoly model with imported parts and It also examines in what situation the Marshall-Lerner condition is satisfied in the model. Section 4 defines and solves for an optimal currency regime. We introduce the exchange rate policy of the monetary authorities of the two countries in order to analyze interdependence and coordination failure between their exchange rate policies. 2. Model (1) Settings Our earlier work, Ito, Ogawa, and Sasaki (1998), considered the question of choosing optimal weights in the basket currency system for a country that exports goods to the United States and Japan. An Asian country was modeled 6 as a one-sector economy where a representative firm assembles parts imported from Japan and the United States into manufactured products. 3 The representative firm in one Asian country was assumed to compete with Japanese firms and/or U.S. firms in the Japanese and U.S. markets. We extend our earlier model to include another neighbor country in the model in order to analyze interactions of the exchange rate policies among Asian countries. We assume that a representative firm in country A imports parts from the United States and Japan and exports its products to markets in the United States, Japan, and country B as well as a domestic market.4 Also, a representative firm in country B imports parts from the United States and Japan and supplies its products to markets in the United States, Japan, and country A as well as a domestic market. We assume that prices of parts from the United States and Japan are given in terms of their production country’s currency. 5 Asian countries export their goods and services mainly to Japan, the United States, and neighboring Asian countries. For example, Thailand exports one-fourth to Japan, one-fifth to NIES (Korea, Singapore, Hong Kong, and Taiwan) and ASEAN-4 countries (Thailand, Philippines, Indonesia, and Malaysia), one-seventh to the United States. These three categories account for more than 7 60 percent. Similarly, Malaysia exports to 22 percent, 34 percent and 17 percent to Japan, to the United States, and to Asian countries, respectively. The sum of these three categories reaches 72 percent. The structure is similar in Indonesia and the Philippines. Table 1 shows the export shares by destination to Japan, the United States, Asian countries, and four European countries (Germany, France, UK, and Italy). Therefore, the assumptions of the model, Country A exports to Japan, the United States, and neighboring country B, are realistic. Each market in countries A and B is supposed to be a duopoly market where both country A and B firms compete with each other. Markets in the United States and Japan are under monopolistic competition. Country A and B firms compete with many domestic firms in each of the U.S. and Japanese markets. They supplies their products in the U.S. and Japanese monopolistically competitive markets given average prices of their domestic products made in the United States and Japan. We assume that prices of the products made in the U.S. and Japan are kept unchanged (exogenous to this model) for simplicity. Moreover, we assume that all firms in countries A and B have identical cost functions. Each firm maximizes its profits in terms of its own home currency. 8 Profits of each firm in countries A and B in terms of its own home currency A and B (πL (L $%) ) is calculated as LL<LLLLLLML π LLLL=+3G T ( 3 -L- I T + ( 3 86L86 J T +
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